Wednesday, November 2, 2016

ATP Bucking The Hedge Fund Trend?

As a number of prominent pension funds stop using external managers they say charge too much in exchange for paltry returns, the biggest pension fund in Denmark is bucking the trend and sticking with the hedge funds it uses.

“In our case, funds have played a small but a good part in our portfolio,” Carsten Stendevad, the chief executive officer of ATP, which oversees about $118 billion in assets, said in an interview in Copenhagen.

The comments stand out at a time when a number of other pension funds have questioned the sense of continuing to rely on hedge funds to generate extra returns. There are plenty of examples of prominent skeptics. Rhode Island’s $7.7 billion pension fund terminated investments in seven hedge funds, including Brevan Howard Asset Management and Och-Ziff Capital Management Group LLC, it said earlier this month.

The largest U.S. pension plan, the California Public Employees’ Retirement System, voted to stop using hedge funds two years ago. Others who have stuck with the hedge funds they outsource investments to have faced criticism as the decision has led to losses, such as the New York state comptroller. Its loyalty to the industry has cost the Common Retirement Fund $3.8 billion in fees and underperformance, the Department of Financial Services in the U.S. said on Oct. 17.

Hedge fund investors pulled $28.2 billion from the industry last quarter, which is more than at any time since the aftermath of the global financial crisis, according to Hedge Fund Research Inc.

ATP declined to say which funds it uses or how much of its portfolio is managed by the industry. Investors can’t lump all external managers into one bucket and there’s plenty of variety left out there for it to still make sense to outsource to hedge funds, Stendevad said.

“There are so many types of hedge funds and we would look at all of them on a multi-year risk-adjusted return basis,” he said. “Looking at the ones we have, they’re quite different.”

ATP divides its investments into two categories: a so-called hedging portfolio, which is by far the larger of the two and designed to guarantee pensions. Its investment portfolio tries to boost the fund’s returns to top up Danes’ pensions. The fund returned 5.8 percent on its investments in the third quarter. For the first nine months, ATP’s investment portfolio returned 12.3 percent. It made money on private equity, bonds, real estate, infrastructure and credit instruments, but lost money on inflation hedges.

Stendevad said the double-digit returns ATP has generated probably aren’t sustainable, citing extreme monetary policies and the uncertainty created by Britain’s decision to turn its back on the European Union.

ATP will only continue using hedge funds as long as the returns justify doing so, Stendevad said.

“Of course the burden of proof is on them to demonstrate that they can deliver strong risk-adjusted returns,” he said. “And of course those who can do that have a good future. There are many that don’t, but that’s true for all active management to demonstrate added value.”

Stendevad, who joined ATP from Citigroup in the U.S. in 2013, is leaving the fund at the end of this year to spend more time with his family. He will be replaced by Christian Hyldahl, who comes from a position as head of asset management at Nordea.

For years they have been the elite of the fund management industry, enjoying colossal fees, gigantic homes and champagne lifestyles.

Now the good times may be over for hedge funds. Investors are taking their money elsewhere.

Last week the $US7.7 billion Rhode Island state pension scheme announced that it would take back half of the $US1.1 billion it had invested with seven hedge funds, including Och-Ziff and Brevan Howard.

Its decision comes after similar moves this year by the New York, New Jersey and Illinois state pension funds, which collectively have redeemed about $US6.5 billion. Kentucky and Massachusetts have also withdrawn money.

According to eVestment, an analytics and data provider, almost $US60 billion has left hedge funds this year, including $US10.3 billion in September.

It is an accelerating trend that began two years ago when the California Public Employees Retirement System (CalPERS), the benchmark for many public sector pension schemes, said that it was redeeming some of its hedge fund investments.

In the context of a $3 trillion industry, $60 billion of withdrawals may not seem like a crisis. But they are causing disquiet.

The main reason is that investors are becoming more cost-conscious. Few are prepared to stump up the gigantic fees charged in the glory years. Chris Ailman, chief investment officer of the $US187 billion California State Teachers Retirement System, spoke for many when in May he said that the industry’s traditional “two-and-twenty” model, where fund managers charge 2 per cent of assets under management and an additional 20 per cent of any profits earned, was broken.

Frankly, investors have decided that many hedge funds do not justify their high fees. According to eVestment, hedge funds delivered a positive return in September for the eighth consecutive month, taking the industry’s average return during the first nine months of 2016 to 4.4 per cent. But that’s poor set against the 9.7 per cent that investment-grade bonds have returned this year, let alone the S&P 500, which was up 6.1 per cent in the same period.

Among the worst performers have been some of the industry’s best-known names. The master fund at Brevan Howard fell by 0.8 per cent in 2014 and by almost 2 per cent last year. To date, it is said to be down by 3.4 per cent this year. Alan Howard, the firm’s billionaire co-founder, has responded by removing management fees on new investments from existing clients. Blaming poor performance on the fund having become too big, after assets under management swelled to $US27 billion in 2014, he has also capped it at $US15 billion.

Another industry legend to have cut fees is Paul Tudor Jones, a hedge fund pioneer, who let go nearly one in six of his staff this year after $US2 billion in redemptions. Other big names to have suffered poor returns this year include John Paulson, the hedgie famed for making billions in 2007 betting on a US housing crash, and Bill Ackman, a regular on America’s business channels.

Several factors have made it harder for the industry to make money. One is ultra-low rates and the rise of passive investing. These mean that many assets now move in tandem, making it harder for investors to add value by stock-picking or by alighting on specific situations or opportunities. Another is that markets are not as inefficient as before. Trading in some assets, notably interest rate products, is now dominated by algorithmic or “black box” traders that make fewer mistakes than human beings. With fewer mortals participating in such markets, there are fewer market anomalies for hedge funds to exploit, making it harder for them to claim an edge.

Poor performance is only one factor, however. Another is growing irritation at the billionaire lifestyles of some of the characters within the industry. This cannot be ignored by those running the retirement funds of public sector workers. Letitia James, the public advocate for New York and the city’s second-highest-ranking public official, told board members of the New York City Employees System this year to dump their hedge fund investments. She told them: “Hedges have underperformed, costing us millions. Let them sell their summer homes and jets and return those fees to their investors.”

Also helping to spark the redemptions have been other reputational hits prompted by tougher action on the part of regulators. Last month Och-Ziff agreed to pay $US412 million in penalties after entering a deferred prosecution agreement to settle claims of alleged bribery in five African countries. Most of the settlement was paid for by Daniel Och, the company’s founder and a former Goldman Sachs trader. Jacob Gottlieb, another big name, is in the process of closing his firm, Visium Asset Management, after one of its fund managers, who subsequently killed himself, was charged with insider trading. Leon Cooperman, another of the industry’s billionaire pioneers, is preparing to fight charges that his firm, Omega Advisors, profited from insider trading.

All these factors have created an unpleasant cocktail for the sector. One of the very best television series this year has been Billions, the story of hedge fund manager Bobby “Axe” Axelrod and Chuck Rhoades, the US attorney who tries to bring him down. The second series airs early next year, but to judge by the way things are going, soon it may look as much of a period piece as the film Wall Street does now.

No doubt, these are hard times in Hedge Fundistan and some investors want these hedge fund gurus to sell their summer homes so they can collect back some of the the gargantuan fees they lost while subsidizing their lavish lifestyles in return for paltry, sub-beta or negative returns.

The only problem is when it comes to hedge funds, most investors, like Rhode Island, are meeting Warren Buffett, and realizing they're not getting what they signed up for, namely, real, uncorrelated and high absolute returns that offer meaningful diversification benefits.

Are there too many hedge funds engaging in the same strategy? No doubt, crowded trades are a huge problem in the industry, especially among the large funds. But the other problem is a lot of hedge funds have gotten way too big for their own good, and more importantly for that of their investors. Too many seem content on collecting that 2% management fee on multibillions but are not offering the returns to justify the hefty fees they charge.

Hedge funds will blame the Fed, low interest rates, ZIRP, NIRP, crowding, high-frequency trading, passive investing, robo-advisors and increased regulations which makes it harder for them to engage in insider trading (and don't kid yourselves, a lot of hedge funds engaged in this illegal activity in the past).

Whatever the reason, investors are fed up and in a deflationary world where rates are stuck at zero, fees eat up a lot of returns, so it becomes harder to justify paying hedge funds big fees, especially when they consistently under-perform markets over a long period.

So what's the answer to hedge fund woes? A nice long bear market? Maybe but don't forget what I always warn you of, most hedge funds stink, charging alpha fees for leveraged beta. This is why their hefty fees are a total disgrace, something which should have been addressed years ago by large institutional investors who have the power collectively to cut these fees down to normal.

Of course, some institutions are more than happy to keep on paying huge fees to hedge funds that (hopefully) are delivering great uncorrelated returns net of fees. Others are tired of playing this game and exiting these investments altogether or putting the screws on their hedge fund managers to lower the fees.

And while some US public pensions are exiting hedge funds or significantly lowering their allocation to them, others like ATP and Ontario Teachers' Pension Plan are still very committed to these funds.

The key difference? When it comes to hedge funds, both ATP and Ontario Teachers know what they're doing, they have committed substantial resources to their hedge fund program and have top-notch professionals sourcing and monitoring these external managers. They also use managed account platforms (like Innocap here in Montreal) to address liquidity and other risks.

Below, take the time to watch to this excellent Bloomberg interview with Bjarne Graven Larsen, OTPP's CIO and former CIO at ATP. He shares a lot in this interviewn on hedge funds, private equity, real assets and liquidity risk, it's truly excellent (also see it here).

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